Valuation in spotlight as SEC mulls expanding investment opportunities

By Ken Tysiac

As the SEC explores new possibilities for “Main Street” investors to have access to offerings that are now considered exempt, private-equity firm financial statement auditors may find even more investors relying on their work.

In June, the SEC issued a concept paper seeking comment on whether to make a broader range of investment opportunities available to investors who are currently considered nonaccredited. This could include opportunities for investors who don’t meet current SEC net-worth requirements to invest in private-equity funds that currently are available only to institutional investors and more wealthy investors.

“How can we help ensure that retail investors have access to the same attractive investment opportunities available to institutional investors in our private markets, while still providing appropriate investor protections?” SEC Chairman Jay Clayton asked the SEC Investor Advisory Committee earlier this month. “Are there changes in our regulation of funds that we should consider, including regulatory changes that would focus on the alignment of retail investor interests and expectations with the interests of fund managers?”

If adopted, these changes could give retail investors access to more lucrative opportunities. But these changes also could make it possible for retail investors who may lack sophistication to lose their hard-earned retirement savings.

Independent auditors of private-equity financial statements play a key role in protecting the interests of all investors. These auditors’ assessment of management’s valuations is essential, according to Tim Mundy, CPA, national managing partner for audit and assurance in the private-equity industry for Deloitte & Touche LLP.

Because a valuation that’s too high or a forecast that’s too optimistic can mislead investors into big losses, the professional skepticism of auditors is critical for investor protection.

“One of the key things in accounting is management’s estimates,” Mundy said. “How well can the auditor rely on management’s estimates?”

Mundy said auditors can inquire whether management is following best practices described in the recently released AICPA Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The guide, published in August, is intended to address the illiquid nature of the market for these investments and the significant subjectivity associated with determining their fair values.

While the guide provides best practices rather than standards enforced by a regulator, Mundy said it helps auditors with their examination of management’s processes.

“It gives some substance for the auditor to point to, to say, ‘Hey, we know you like running DCF [discounted cash flow] models, but what about a GPC [guideline public company] model?’” Mundy said. “‘What about comparing your business to other transactions in the industry? What about adding more substance to your process and follow-on the consistency of that process from year after year. And part of that is, what about back-testing those assumptions?’”

According to the guide, investment companies often find it beneficial to perform periodic (for example, quarterly) back-testing on investments that have had subsequent realizations or liquidity events, comparing the implied value from the transaction to the fair value estimate from the most recent analysis as well as valuations from other prior periods that may be deemed relevant. Back-testing provides ongoing feedback that could enhance the rigor and controls around the valuation processes for periodic fair value estimates.

Meanwhile, Mundy said investors need to make sure they ask the right questions before committing their money. Private-equity funds can provide excellent opportunities for returns, but they also have the potential to result in big losses for investors.

“Do your homework,” Mundy said. “It’s your money. Don’t expect because it’s a big organization or a great organization that’s done great in the past [that it will perform well]. Make sure you understand what they’re doing.”

Ken Tysiac ( is the JofA’s editorial director.

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